Those who worry about debt and think it is a major problem are correct. Unfortunately they often confuse two types of debt, namely, private sector debt and government debt. These debts are entirely different. They are best considered as opposites. Government debt is, in fact, private sector savings, and vica versa. Indeed the only way that that the private sector as a whole can accumulate net financial assets is by the government sector spending more into the economy than they remove through taxation, i.e. by running a deficit.
Sound confusing? Think of it this way. The government has a legal monopoly on creating debt-free money. It creates this money by spending. If the private sector AS A WHOLE is trying to accumulate money (i.e. save) this can only come from the government spending. When government's tax they are removing money from the private sector. The annual difference between taxation and spending (the deficit) represents the amount of money created each year by the government. To repeat, government debt represents the total amount of debt-free money that the government has created. It is also exactly equal to the net financial wealth of the private sector.
The big macroeconomic change over the past 40 years has been the rise in private sector debt relative to income. This has risen to over 300% of GDP in many countries. This change was simply ignored by mainstream economists and policymakers. The usual justification was that private sector debt was matched my private sector credit so net private sector debt was zero. This is odd since it is obvious that there is a limit to how much debt can be carried by anyone which is set by their income. As debt rises relative to income an ever greater proportion of income has to be spent on servicing the debt.
The financial collapse was a result of defaulting on this debt, which created panic in the financial sector, which froze up the payment system. This induced a deep global recession which prompted the aggregate private sector cutting its spending and increasing its saving. This is entirely appropriate but it has depressed growth, since growth requires spending, and when spending is diverted to savings, growth is depressed. Governments stepped in to prevent collapse. This resulted in a big increase in deficits and government debt, which had been at record low levels in most countries before the financial crisis.
Remember that the aggregate private sector can only save if the government sector runs a deficit. Government deficits will continue to remain high precisely because the private sector is desperately trying to save by reducing its spending, which depresses growth and thus government tax revenue.
When understood this way it should be clear that attempts by the government to cut the deficit prevents the private sector from saving at their desired level. Does this austerity seem sensible when private sector debt is still at record high levels? Of course not. In fact it is counterproductive because, by depressing growth and increasing unemployment, austerity increases the private sector's desire to save. When you see your income go down and everyone else's is dropping, does it make sense to borrow more money?
Of course many will argue that, despite the damaging effect austerity has on the economy it is necessary to reduce the deficit because if we don't the government would have to pay very high interest rates to borrow money. This is an understandable mistake to make given what we have seen in the Eurozone. The difference is that Eurozone governments do not issue their own currency. They have to borrow it, and they do not control the interest rates for borrowing. This is unusual. Normally governments issue their own currency and they can set interest rates at whatever level they choose. Because of this they can never be forced to default on their own debt. That is why interest rates on government borrowing are so low in the US, the UK and Japan. There is no shortage of people keen to buy government debt even at low interest rates. Why? Because we are all still worried about the banking system, and when governments issue the currency then their debt is the safest place to store savings.
Instead of worrying about government debt policymakers should be focusing on accommodating the private sector's desire to save by increasing their deficits. Probably the best way to do this is to cut taxes, especially regressive taxes such as VAT and National Insurance. This would provide an immediate boost to demand. The deficit should be kept high until there are signs that the economy is running at full capacity. The clearest evidence of would be an increase in inflation. When this happens the deficit should be cut. If unemployment is till high then this suggests that there are structural constraints causing bottlenecks to economic growth. That is the time to focus on structural reforms to increase efficiency and eliminate bottlenecks. It should be clear from where inflation is greatest where those bottlenecks are.
Instead what the government is doing now is:
-aggressively trying to cut the deficit, when demand is already low
-trying to encourage private sector borrowing, when private sector debt is too high
-wasting time and money on structural reform without there being any evidence for structural problems.
The scale of their ignorance and incompetence is breathtaking.
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